Last Update: July 2021
Trading junkies love to measure things. I have an ever-growing stable of scales, gauges, and barometers to assess fundamental and technical variables galore. Want to know the valuation of Apple? Why, take your pick. You have the P/E ratio, its hotly contested variant CAPE, and the PEG ratio. But why stop there? Check out Price/Cash Flow and Price/Sales while you’re at it. …and don’t forget Enterprise Value. You mustn’t forget that one.
Don’t even get me started on technical indicators. We don’t have enough digital ink to cover the scores of redundant methods for measuring trend and momentum.
Do you know what I really like measuring, though?
Emotions. Feelings. Something we technicians like to call sentiment.
It’s like taking the markets temperature. While the emotions of the masses certainly run the gambit, the two kingpins are fear and greed. Or, perhaps more accurately, fear and complacency.
The benefit of tapping into market sentiment is that it helps identify potential market turning points. Perhaps you’ve heard this, or some variation of it, before:
“The crowd is right during the trend, but wrong at both ends.”
So says Humphrey B. Neill, known to many as the father of contrarian investing. When fear is thick and the lion’s share of the Wall Street lemmings have panicked, the environment is ripe for a reversal. Alternatively, when complacency has seeped into every corner of the Street, it’s usually high time for some type of correction. In less flowery terms, when everyone is panicking, contrarian thought says you should buy. When everyone is greedy, you should sell.
The logical question, then, is how to determine when emotions have reached either extreme. For that you need some type of market sentiment gauge. Though there are many perhaps none is as popular as the CBOE Volatility Index.
At least, that’s its formal name. Many know it as simply the VIX. The CBOE touts the VIX as “the world’s premier barometer of investor sentiment and market volatility”, and rightfully so. It’s the go-to indicator used by professionals to determine the level of fear in the marketplace.
At its core, the VIX is a measure of implied volatility for options on the S&P 500 Index. Basically, if demand for options rises, it lifts option premiums causing an increase in the VIX. If demand for options falls, then option premiums shrink causing a decrease in the VIX.
When measuring emotions, the actions of market participants is a better tell than their words. Rather than polling participants to determine their state of mind, we can track their behavior. One thing investors do when they are fearful is buy options for protection. This uptick in demand drives the VIX higher, which signals increased anxiety levels permeating Wall Street.
Since emotions are always changing, the VIX is constantly in motion. The strongest signals occur when it reaches an extreme. If you go back and look at any major pivot low in the S&P 500, you’ll see it was accompanied by a substantial spike in the VIX.
The latest episode driven by the Greece drama and Chinese stock implosion is quite instructive. Fear surrounding both events was high enough to deliver a 4.5% haircut to the S&P 500 in recent weeks. The stock swoon sent investors scurrying into the options market in search of protection. Naturally, the increased demand inflated option premiums driving the VIX sharply higher.
Contrarians should have been eyeing the VIX spike as a sign that fear had potentially reached unsustainable levels, which suggested a market rebound was in the offing. This past week delivered just such an outcome. As a matter of fact, the price recovery was virtually perfect for any traders who had the guts to step up and buy amid the fear fest.
Stock prices have rebounded and fear has dissipated from the marketplace as quickly as it came in. The VIX, which had rallied as high as 20 and bumping its head above the upper Bollinger band in the process, has now returned to pre-crisis levels.
You’ll see this dynamic play out each and every time a new crisis rolls into Wall Street to spook investors. I suggest you memorize it.
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5 Replies to “Tales of a Technician: The Fear-O-Meter”
Great article, Tyler. Thanks.
Thanks Tyler – great information!
Another good read Ty!
Great stuff, Ty, thanks!
Awesome article Tyler. Thanks.
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